In so-called combination trade a bidder places on the market a single price for a combination of different financial instruments. These individual instruments may be shares, options etc., or any combination thereof. A combination order could for example be “Sell 2 instruments A, buy 3 instruments B for a combination net price of $10”.
A combination order is listed as a single instrument on the market. Thus, in order for a combination order to be executed, all the involved instruments must be traded as a single order. This combination instrument could be a or a standard combination defined by the system operator or a so called tailor made combination (TMC) defined by a party trading in the system. The strategy is the specific relation between the different instruments making up the combination, i.e., the ratio between the amount of the respective instruments traded. The number of different instruments, or so-called legs, could vary from two, as in the example above, up to four or even more, although two is the conventional number of legs in a combination order.
When a combination order is executed, the price for the different kinds of instruments traded has to be determined, the so-called leg prices. In the above given example, there is one leg price for the two instruments A and another leg price for the three instruments B. One reason for this need to determine leg prices is because the different instruments could have been traded for different clients of the broker, for example. Another reason could be that that the leg prices should be booked on different accounts.
When determining the leg prices, first the market is looked at and prices are assigned to the different legs. However, in the end it is common to end up with a set of leg prices that does not match the combination net price. Therefore so-called seed price values which are first estimates of the leg prices are used. These seed price values are subsequently modified if required so as to arrive to a set of leg prices that matches the combination price.
One way of finding the seed price values is to look at the current bid and ask prices on the market for the individual instruments and assign the leg prices accordingly in any desired order. In the situation where the market has just opened and there are no orders and there have been no trades on all the series, the seed price value for the last leg will be the theoretical value or default values will be used. The theoretical value is the value of an instrument as determined by a specific model based on the model's input parameters. This could clearly lead to the legs trading at prices totally out of the market. As soon as real orders will be placed on the series and/or trades take place (i.e. a “last paid” exists), the theoretical value will no longer be used as seed price value.
A market maker is a trader responsible for providing quotes. Thus, the market maker is obliged to give an estimated bid or ask price for an instrument on demand. This is another way of finding the seed price values.
In current stock market exchange systems, all calculations are computer generated. In some prior art computer systems, when generating the leg prices for a combination trade, two algorithms are used. First, the “ordinary price algorithm” is used, which tries to use seed price values taken from the market (i.e. bid, ask, theoretical value, last bid or ask etc.). If the ordinary price algorithm for some reason fails, a “secondary price algorithm” is used, which is called when all attempts made by the “ordinary” algorithm fail.
The main difference between the two algorithms is that the latter does not make use of the current market picture to define a seed price value and therefore generates whatever kind of prices that do match the combination net.
When trading combination orders, and particularly tailor made combination orders, a few situations could lead to the legs trading at incorrect prices. In this case incorrect prices do not necessarily mean that the combination net is not matched but that the leg prices are consistent with the market picture but do not comply with the tick step rules, i.e., the rules relating to the minimum price fluctuation available in a marketplace expressed in terms of points, ordinary fractions, or decimal fractions of a point of the price or rate. An example thereof is given in Table 1a below.
TABLE 1aNetPay/ActionInstrumentRatioLeg PricesPriceReceiveBuyA8859.0SellB−250.46862.0Paywherein “Action” is either Buy or Sell, “Instrument” is a kind of financial instrument in the respective leg, “Ratio” is the number of instruments traded, “Leg Price” is the price that could be generated by the primary or secondary price algorithm, “Net Price” is the total price set in the order, and “Pay/Receive” indicates whether the Net Price is positive or negative.
An example of tick size rules for instruments A and B is given in Table 1b below. It reports the allowed tick steps for different interval and it also indicates that only one decimal is allowed.
TABLE 1bStep sizeLower limitUpper limit0.10.10.90.51.049.51509991010009999999
The market picture for the instruments A and B is given in FIG. 1c below.
TABLE 1cInstrumentBidAskA938.0938.0B19.527.5
In the above, example the current theoretical value for the A leg price is 938 and the combination net is 6862. The ordinary algorithm sets the A leg to the theoretical value and calculates the B leg price as follows:B Leg price=(8*938−6862)/25=24.72
This price, which is consistent with the market picture, is discarded because the tick step rule allows only one decimal, see FIG. 1b. The result is that the system uses the secondary price algorithm, which will generate trades for 859 for the A leg, i.e., the original leg price, and 0.4 for the B leg. These had to be manually re-booked to e.g. 939 and 26. This adds a further step in the leg price generation, thus introducing associated costs and delays.
It could also be so that legs trade at prices that are too far away from the actual spread on the market. Also in this case the leg prices are usually not compliant with the tick step rules.
Thus, a first problem in prior art systems is that the calculated leg prices do not comply with the tick step rules. This in turn results in that the system is forced to use the secondary price algorithm.
The second problem is a result of the use of the secondary algorithm as all the attempts made by the ordinary one have failed to find valid prices. Whenever the “ordinary” algorithm fails and the secondary price algorithm is called prices that are totally unrelated to the market picture could be generated, as long as the combination net price is matched. This is done in order to make the trade possible. The “incorrect” leg prices will then need to be re-booked manually by the market control to more appropriate prices.
When calling the secondary algorithm usually no checks are made that the generated prices are compliant with the allowed tick steps but the system only checks that the prices have the correct number of decimals.